Interest-only or principal and interest for investment loans?

When you set up an investment loan, one of the first choices is the repayment type. Interest-only (IO) and principal and interest (P&I) each suit different situations. Here's how they work, the trade-offs, and the questions to ask before you decide.

How each repayment type works

Principal and interest repayments cover the interest plus part of the amount you borrowed. Each payment reduces the balance, so the loan is paid off by the end of the term.

Interest-only repayments cover only the interest for a set period. Moneysmart explains that during that period the amount you borrowed doesn't reduce. When the interest-only period ends, the loan switches to principal and interest and repayments go up.

The case for interest-only

• Lower repayments at the start, which can help cash flow while the property is new to you or rent is still settling.
• Flexibility. Spare cash can go into an offset account or towards non-deductible debt, such as your own home loan. Your accountant can advise how this fits your situation.
• Short-term needs, such as a construction period or a planned sale within a few years.

The trade-offs

• You pay more interest over the life of the loan, because the balance stays higher for longer. Moneysmart also notes interest-only loans may carry a higher interest rate than P&I.
• Repayments rise when the IO period ends. The full balance then has to be repaid over fewer years, so the jump can be significant.
• No equity is built from repayments. Any equity growth relies on the property's value rising. If values fall, you have less buffer.
• Extending IO isn't automatic. When the period ends, a lender may reassess you before agreeing to a further interest-only term.

An illustrative example

Round numbers for illustration only. Imagine a $500,000 investment loan over 30 years with the first five years interest-only. For those five years you pay interest only and still owe $500,000 at the end. From year six, you repay the full $500,000 over the remaining 25 years, so repayments step up noticeably. With P&I from day one, repayments are higher at the start but stay more even, and by year six you'd owe less than $500,000.

Questions to ask yourself

1. Can you afford P&I repayments now? If you can, think about why you'd choose IO. If you can't, think about what changes before the IO period ends.
2. What's your plan for the property? Holding for decades, selling in a few years, or renovating all point to different structures.
3. Do you have non-deductible debt, such as your own home loan? Many investors focus on paying that down first. Your accountant can advise on how that affects you.
4. How stable is your income? For roster and FIFO workers, overtime can change with the project. Plan on repayments you could manage on your base income.
5. What happens at the end of the IO period? Run the numbers for the higher repayments now, so it isn't a shock later.

How lenders view it

Lenders generally assess your borrowing capacity on the higher repayments that apply after the interest-only period ends. Some lenders limit how long the IO period can be, or price IO loans differently. Policies vary, so the repayment type you want can affect which lenders suit you.

A combination can work

You don't always have to pick one. Some investors split the loan, with part on IO and part on P&I. Others start on IO with a plan to switch to P&I after a set event, such as paying off another debt. An offset account linked to an IO loan can reduce the interest charged while keeping cash available. The structure that suits you depends on your goals and your accountant's advice on the tax side.

Don't forget the end date

Put the date your IO period ends in your calendar. A few months beforehand, review your options: switch to P&I, ask about extending IO, or refinance. Our refinance page covers what's involved in a review. If you're buying in the Bowen Basin, our Moranbah home loans page explains local lending considerations, and our investment loans page covers the wider picture.

Talk it through

We can run both repayment types against your income and plans, so you can see the numbers side by side before you decide. Talk to your accountant about the tax side. Call or text us on 0458 773 002, or book a free assessment. For most home loans there's no broker fee; any fee is disclosed upfront in our Credit Guide.

Common questions

Sources

• Moneysmart: Interest-only home loans

This guide is general information only and doesn't take into account your objectives, financial situation or needs. Talk to us about your circumstances before acting on it. Related: Investment loans.